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Bank Rate &dash; first rise for more than 10 years

On 2 November, the Bank of England raised Bank rate from 0.25% to 0.5% – the first rise since July 2007. But was now the right time to raise interest rates? Seven of the nine-person Monetary Policy Committee voted to do so; two voted to keep Bank Rate at 0.25%.

Raising the rate, on first sight, may seem a surprising decision as growth remains sluggish. Indeed, the two MPC members who voted against the rise argued that wage growth was too weak to justify the rise. Also, inflation is likely to fall as the effects of the Brexit-vote-induced depreciation of sterling on prices feeds through the economy. In other words, prices are likely to settle at the new higher levels but will not carry on rising – at least not at the same rate.

So why did the other seven members vote to raise Bank Rate. There are three main arguments:

•

Inflation, at 3%, is above the target of 2% and is likely to stay above the target if interest rates are not raised.

•

There is little spare capacity in the economy, with low unemployment. There is no shortage of aggregate demand relative to output.

•

With productivity growth being negligible and persistently below that before the financial crisis, aggregate demand, although growing slower than in the past, is growing excessively relative to the growth in aggregate supply.

As the Governor stated at the press conference:

In many respects, the decision today is straightforward: with inflation high, slack disappearing, and the economy growing at rates above its speed limit, inflation is unlikely to return to the 2% target without some increase in interest rates.

But, of course, the MPC’s forecasts may turn out to be incorrect. Many things are hard to predict. These include: the outcomes of the Brexit negotiations; consumer and business confidence and their effects on consumption and investment; levels of growth in other countries and their effects on UK exports; and the effects of the higher interest rates on saving and borrowing and hence on aggregate demand.

The Bank of England is well aware of these uncertainties. Although it plans two more rises in the coming months and then Bank Rate remaining at 1% for some time, this is based on its current assessment of the outlook for the economy. If circumstances change, the Bank will adjust the timing and total amount of future interest rate changes.

There are, however, dangers in the rise in interest rates. Household debt is at very high levels and, although the cost of servicing these debts is relatively low, even a rise in interest rates of just 0.25 percentage points can represent a large percentage increase. For example, a rise in a typical variable mortgage interest rate from 4.25% to 4.5% represents a 5.9% increase. Any resulting decline in consumer spending could dent business confidence and reduce investment.

Nevertheless, the Bank estimates that the effect of higher mortgage rates is likely to be small, given that some 60% of mortgages are at fixed rates. However, people need to refinance such rates every two or three years and may also worry about the rises to come promised by the Bank.

Questions

Why did the majority of MPC members feel that now was the right time to raise interest rates whereas a month ago was the wrong time?

Why did the exchange rate fall when the announcement was made?

How does a monetary policy of targeting the rate of inflation affect the balance between aggregate demand and aggregate supply?

Can monetary policy affect potential output, or only actual output?

If recent forecasts have downgraded productivity growth and hence long-term economic growth, does this support the argument for raising interest rates or does it suggest that monetary policy should be more expansionary?

Why does the MPC effectively target inflation in the future (typically in 24 months’ time) rather than inflation today? Note that Mark Carney at the press conference said, “… it isn’t so much where inflation is now, but where it’s going that concerns us.”

To what extent can the Bank of England’s monetary policy be described as ‘discretionary’?